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Entrepreneurs: Are You Lost? How To Tell Where You Are in the VC Fundraising Process

As in many other situations involving asymmetric power relationships, VC’s (who usually have the power) like to preserve optionality with startups in which they’re interested (as I wrote here).  That is, VCs generally will try to keep interesting deals “on the hook” until they have to make a decision (usually driven primarily by the concern that other VC’s are converging on the deal).  From the VC’s POV, this is eminently rational.  Why make a risky decision (i.e., whether to invest) until you have to – waiting may allow more data to emerge that will inform/improve your decision.  Accordingly, VCs, good ones anyway, become quite skilled at saying things, whether or not true, that make entrepreneurs think there’s serious interest in their deal.

For the entrepreneur, this frequently leads to disappointment.

Experienced entrepreneurs know that they cannot rely on anything a VC says about where the VC really stands.  As I wrote here, the only way to tell if a VC is interested in your deal is whether they are re-arranging their schedule to work on your deal.  If you're not pushing other stuff off their calendar, you're making no progress.  Whenever a VC misses a deadline in getting back to you, it’s a bad sign.  In general, given how time-consuming the fundraising process is,  the entrepreneur should consider that VC a “pass”, and focus fundraising efforts elsewhere.

As an aside, in the roughly 20 years I spent as a lawyer representing entrepreneurs, I used to tell my clients that the worst curse they could inveigh against a competitor was that the competitor had to seek venture financing.  That guaranteed that the management team of the competitor would have to take their eye off the ball for 3-6 months.

Even “scheduling-altering behavior” by the VC, however, is not always a good indicator of an eventual offer.  Many deals evoke an initial burst of activity by a VC (especially if the deal is perceived as “hot”), only to have the activity level fade and turn into a “pass”.  Not infrequently, in my experience in representing entrepreneurs as their lawyer, the last thing an entrepreneur may hear from a VC before “We’re going to pass.” is “Would you consider raising a bigger round, so we could write a bigger check?”.  The only certain way (as I wrote here) for entrepreneurs to know their deal is closing: when the VC’s wire transfer hits their account.  Until then, best to remain skeptical, and keep plugging.

Further aside:  VC’s often (indeed, most often for the vast majority of VCs) “communicate” that they’re not interested in an entrepreneur’s deal by going radio silent.  The most frequent lament from entrepreneurs is that most VC’s with whom they have met never get back to them, despite promising to do so.  This leads to the final lesson of this post:  if you have twice written to a VC, without reply, it’s a pass, and you should move on.  For some reason, it’s a hard lesson for many VCs to learn that the second-best answer to an entrepreneur is a quick “no”, even with no explanation. For entrepreneurs who are fundraising, open loops are mentally and emotionally draining, so the fewer the better.

"On Demand" Eating the World of Music, Too.

It's now a truism, or a cliche, to mention how the "On-Demand" economy is eating the world of personal services (Uber, Lyft, AirBnB, Task Rabbit, Postmates, Instacart and dozens of others).  Among a bunch of other reasons, millennials don't want to own things in the same way that we, their parents, did/do.  What is lesser remarked, but equally disruptive to a huge market, is that, as noted here in the Financial Times, the "On Demand" business model is also eating the music world - streaming has now outpaced downloads, with disruptive repercussions for an already beleaguered industry.

1998 -- 1999 are Calling and They Want their Wild Abandon Back!

I love Tesla, and am a huge fan of Elon Musk (a former client from my lawyer days).

But, reading this in a place like the FT (as opposed to (the long defunct) "Industry Standard", as well as "Upside", "Red Herring", "Wired") made the hair on the back of my neck stand up in alarm -- I thought I was having LSD flashbacks to 1998 - 1999, when statements like these (this one from today's FT) were thrown about with abandon:

  "Still, if you try to be rational, you are missing a big point in Mr Musk’s favour. Silicon Valley is currently obsessed with cars. More than that, those who mutter about the lessons of the last dotcom crash could be missing out on the next Amazon. If you had written off Jeff Bezos’ hubris, you would have missed one of the great investments of our age. You buy Tesla today so that in years to come, you can say you were there."

Apple and Mobile Web Ad Blockers -- Not What It Seems?

Interesting story in WSJ about how Apple's new mobile web ad blockers are upsetting mobile web publishers and advertisers.  The arms race continues, with publishers/advertisers -> ad blockers -> consulting firms that help publishers/advertisers combat ad blockers!

Curious twist for the cynical mind: Apple's strategy only affects mobile web ads.  This should drive more ad revenue towards the mobile, in-app model. Wait a minute!  That will hurt mobile web advertisers and publishers (from whom Apple makes no money via Safari), but will help Apple (with greater in-app advertising)!  What a coincidence.

Wonder if, as Tim Cook claims, it's really about browser performance after all?

Advice on Hiring

Don’t hire people about whom you have doubts. 

One will make plenty of hiring mistakes during one's business career by hiring people about whom one had no doubts, but who, nevertheless, don’t work out. 

But, the failure rate on people about whom you have doubts is far higher.

Trust your doubts, especially as you gain hiring experience.  The best "gut" is fallible -- one will hire people who surprise one by not working out -- but still one's best guide.

Startups and VCs -- The Secret Arena of Competition

Every startup seeking financing from VCs faces two kinds of competition: known and unknown.

Known:  Every startup pitch should have a "Competition" slide, in which it lists and (briefly) describes the bases of competition and the companies with whom it competes in the market it's trying to exploit.  There are two main variations on how to present this: (1) a "magic quadrant" with two dimensions of competition that result in the startup being alone (or a good distance away from the other listed competitors) in the upper right quadrant, or (2) a matrix with competitor's names down/across one axis, and features/attributes across the other, with all the good features/attributes for the startup filled in or checked, and the features/attributes for the competitors mostly not.  VCs, occasionally, chuckle at particularly creative competition slides, but do pay attention to them as a part of the IQ test they implicitly administer to entrepreneurs throughout the due diligence process.

So, Entrepreneurs, you should absolutely have a competition slide, and you should be honest in the depiction of your competitors.   VCs, because they see so many deals, usually have a good sense of the competitive landscape, so overly creative attempts to downplay competition can work against you. 

• Here's more that I've written on the "Goldilocks" level of competition.

Unknown:  Equally importantly, however, there is an invisible set of competitors that you may never come to know.  These are all the other startups on your VC's desk competing for the VC's attention.  All, or certainly most, may never compete with you in the market (or even other areas of invisible competition, such as for talent, PR/press coverage, rental space, etc.), but you need to out-compete them, nevertheless, or you won't get financing.

VCs spend a lot of their time getting pitched.  Because VCs are human, even the best, kindest hearted, ones get jaded, or, at least, inured to the process over time.

This means that you need to grab their attention early in the process of engaging with them, from the minute you are introduced (as noted here, you will always need a warm introduction to the VC to be considered at all), through the first presentation you make to them.  Elsewhere, I have called this "Create the Aha Moment Early", and urged entrepreneurs to be active in their descriptions of their businesses.

So, be aware of the two different fields of competition. They both require careful thought and preparation.

Now, It's D2C eCommerce That's Eating the World

As pointed out in this article in yesterday's TechCrunch, yet another company, Away, is pursuing the D2C business model -- another instance of the evolution of eCommerce from eCommerce 1.0 to eCommerce 2.0.

The article cites WarbyParker & Casper.  Hem.com is another very interesting eCommerce 2.0 company, distributing a growing, full-stack (i.e., Hem designs, manufactures and ships its own, Hem-branded products directly to end-user customers), proprietary (i.e., you can only get Hem products from Hem) selection of furniture and home furnishings (note: Hem is one of my "Sherpa" companies).

eCommerce 1.0 was, essentially, taking paper catalogs and putting them online.  The eCommerce merchant served the same purpose as offline retailers:  aggregating products made by third parties and selling them through a more efficient distribution channel.  Goods sold this way were often, but not always, sold at lower prices, because fewer parties were involved in the distribution chain, so fewer markups took place between the manufacturer and the end customer.  Amazon is the canonical example of this. 

eCommerce 1.0 had multiple benefits over offline retail in addition to (frequently) lower costs. These included broader selection (the experience was like being able to search the entire warehouse, not just the 2,500 square foot store on Main Street), search tools, online configuration tools, etc., etc., etc.

But, eCommerce 1.0 was still a multi-level distribution business, with the retailer buying the products from third parties and putting them through a more efficient distribution chain.  Thus, the fundamental margin structure of eCommerce 1.0 businesses continued to be analogous to those of offline retailers -- because each of the manufacturer and the distributor (the eCommerce merchant) had to make significant margins (because they were separate businesses), eCommerce 1.0 businesses soon hit their own cost barriers.

eCommerce 2.0 companies, like Hem, WarbyParker, Casper and Away (and others) have large margin advantages over non-integrated merchants because they capture all the margin between the sourcing of the product and the shipping of the product to the end customer.  This explains the growing number of companies being formed to pursue the eCommerce 2.0 model.

Many eCommerce 1.0 merchants are adopting eCommerce 2.0 strategies.  Amazon sells an increasing number of Amazon-branded products, on which it, presumably, makes better margins, as does eBags, the original eCommerce 1.0 merchant that was the spiritual precursor of Away.  Offline merchants, particularly grocery stores, have tried this strategy with own-branded or plain generic products, but have not focused on it as an exclusive strategy.

Interesting that an offline presence is creeping back into the eCommerce 2.0 mix. WarbyParker has a growing number of stores, and Hem is planning pop up stores in selected cities as the business grows.  These efforts start as ways to contribute to the marketing efforts, but can -- e.g.,  Apple Stores --- grow to become an integral part of the model.  But, even these offline efforts are still eCommerce 2.0-related,  because they only offer products made by the merchant themselves (e.g., Apple Stores vs. Best Buy stores).

Entrepreneur's Prerogative -- Making Mistakes

Out there in business advice land, there's lots of writing about how good company cultures celebrate, encourage, or, at least accommodate, mistakes.  Much of it is pablum, but there are some OK treatments of the topic (here's one I stumbled across).

Some other examples include: (1) An old friend, and founding member of the digerati, Esther Dyson, used to e-sign all her email with "Always Make New Mistakes" and (2) the founder of several companies that I've worked with over the years exhorted his employees to "Make Mistakes, but Don't Tank the Company."

As Stephen Colbert would have said, there's "truthiness" in all of these statements.  But, sophisticated management teams understand the nuances of the situation.  Too often, the cultural tagline, "it's OK to make mistakes", gets interpreted as "it's OK to move fast and be careless".  That is not a way to build a successful company. Intelligence and common sense need to be applied.

Here's my take on the way to express the approach that good company cultures should take towards making mistakes.  I call it the Ten Commandments of Making Mistakes.

It's OK to make mistakes if you:

1. were paying attention at the time
2. were not affirmatively trying to make a mistake
3. had both planned and prepared before making the mistake, and weren't being careless in doing whatever resulted in the mistake
4. were not repeating a mistake that, while new to you, had already been made by others in your Company
5. weren't making a mistake that, with some minimum amount of research, you would have found out that others had already made
6. had checked with some others before making the mistake
7. aren't making a mistake that tanks the Company
8. were obeying a law of minimum common sense while making the mistake
9. admit it was a mistake when that becomes apparent, and
10. spend time learning from the mistake -- so that you don't repeat it.

Unfortunately, this is way to much to fit in a company culture statement, but maybe management teams can figure out how to let it percolate out into the Company over time.

P.S., I'd love to get other formulations and approaches to the culture of making mistakes.

Entrepreneurs: Make Sure You Prepare Your Customers for Reference Calls

Practice varies, but quite often the last two due diligence items a VC will want to do before offering a term sheet are (1) personal references and (2) customer references.  These should be done last because it's easy to "burn out" the person(s) giving the reference(s), and, so, entrepreneurs should not deplete that resource unless the prospective investor has done all their other due diligence and is on  the verge of making an offer.  That is, the entrepreneur should get the VC to commit that these are the last two due diligence items they intend to do (other than legal due diligence, which is always done after a term sheet is proferred).

There are certainly risks in personal reference calls going badly, but most people in the business world have made, and given, reference calls, so I'm not going to spend any time on that topic.

Customer reference calls, however, can go off the rails if not prepared for properly, and here are some tips on how to maximize the chances they go well.

Person Seeking the Reference:  It is entirely within the bounds of propriety for the entrepreneur to review the questions that the VC plans to ask of the customer reference.  The entrepreneur should note that the VC is free to request to ask anything the VC wants.  The entrepreneur's choice is to comply, negotiate away the question (very unlikely and risky from a "makes the VC nervous" perspective) or get money from someone else.  But, that said, the entrepreneur should understand what the VC is planning to ask about so the entrepreneur can prepare the customer for the call.

Customer Giving the Reference:

• Things That Can Go Wrong: It's important to realize that, for many customers, this might be the first time they've ever done a "customer" reference call for a vendor who's seeking financing.  It can seem mysterious and ambiguous; at the very least, there's not a widespread understanding of the purpose of the call.  Here are some examples:

•  "I need to appear smart":  Often, the customer employee will feel the need to appear smart to the VC.  Probably, this is part standard human reaction to a situation in which it's easy to feel like you're being "tested" on your knowledge of the vendor, their product and the industry, exacerbated by some nebulous sense that the VC must be important (or else, why would the vendor have asked me to do the call?).  In any event, I have seen this movie, and it usually involves the customer employee struggling to appear "even-handed" in their evaluation of the product, so as not to appear naively enthusiastic.  Particularly when the personality of the customer employee is not naturally enthusiastic, this can (inadvertently) present the picture of a customer that isn't all that happy with the product.  Not good on a VC due diligence call.

• "I Don't Want to Be Blamed if the Investment Doesn't Work Out":  Because the VC is calling the customer as part of the process of deciding whether to invest in the vendor, customers can feel that the VC is looking to them to be an integral part of the investment decision -- in the extreme, it can feel like the VC is asking the customer whether or not the VC should make the investment (I've heard VCs actually ask customers a version of this question: "I know you're not in a position to know, and its clearly our call to make, but, just curious, would you make this investment?").  No surprise, this can make the customer very cautious about sounding too enthusiastic.  It's vitally important that the customer not feel that, by giving a good, enthusiastic reference, he is, any way, "on the hook" for the VC's decision whether or not to invest.

How to Avoid the Problem(s):

• For these, and other reasons, the entrepreneur should prepare the customer for the reference call.  This includes, among other things, alerting the customer to the areas which the VC wants to explore, so the customer can have ready answers.  But, the most important part of preparing the customer is to explain the purpose of the call and what the VC wants to get out of the call.  To reiterate, unlike personal references, which are sought and given frequently -- and with which most (relevant) folks are familiar -- customers may never have given a VC reference, and inadvertently harm the financing process through their misunderstanding.

• Here's an example:  I've recently had a VC seek a customer reference call with on of my "Sherpa" company's customers.  The call was with a mid-level employee of the customer who "owned" the relationship in the customer organization, so the logical person to whom the VC should have spoken.  It was this person's first such call (we didn't know this at the time -- the person was senior enough that we, more or less, assumed they knew the drill -- which they didn't), and the company seeking financing didn't prepare the customer for the call at all.  The call ended up being a disaster (but for the wrong reasons), with the VC ultimately backing out.  The reasons were that the customer employee giving the reference found the VC aggressive, "probing", doubting, "looking for all the weaknesses", and a bunch of other stuff.  The customer employee got flustered, gave bad or rambling (and defensive) answers to the questions.  And, in "self-defense" started obliquely criticizing the vendor, just to (1) "appear smart", and (2) deflect the questions that were misperceived as attacks.  Finally, the customer employee rang the alarm internally that the company seeking financing was near bankruptcy, based (wrongly) on the fact that they were fundraising, and the VC was so aggressive in their questioning.

The lesson: Always prep your customers before they do reference calls with VCs.  This is not to induce them to prevaricate in any way, but, rather, to let them know, pre-emptively, that the VC will ask probing questions, might seem aggressive in some of the questions, may sound somewhat doubting about the company's prospects, may ask them whether, in their opinion, the VC should make the investment, and other similarly potentially confounding gambits.  Importantly, that this is normal, and the purpose of the call is to probe to make sure customers like the product -- and that it is consistent for the employee to answer with (genuine) enthusiasm for the product while appearing "smart" about the industry.  And, finally/finally, that the fact that the company is out fundraising is a good thing, normal in the progress of successful companies -- not a worrying sign of impending financial problems.

Kissing Your Sister on the Cheek -- VCs and Risk Asymmetry

There's an interesting article today by Sarah Lacy in Pando Daily.  In it, she analyzes why there seem to have been a lot of high-profile failures among "celebrity" startups that had raised tons of money, and were being touted as doing very well by their boards and investors up to the point at which they, abruptly and with no notice, failed.  In addition, she laments the fact that, in today's environment with the growing cult of the celebrity entrepreneur, boards seem willing to let "celebrity" startups spend all their money despite the obvious fact that the business is going to fail.  Here's what she wrote:

"Witness Sean Parker’s disastrous Airtime. One of the old school investors in the round advocated that the capital be returned and it be closed down. Not a crazy request: It clearly wasn’t working. But other investors were happy to play “the good cop,” saying they still believed in Parker and were happy to let the bet ride. And those good cops are making a savvy move. They’d already written that money off, and don’t get any blood on their hands. If it goes under quickly? So much the better. They can focus more time on the winners."

In addition to Sarah's analysis of this phenomenon, and why it seems to be happening more frequently (with almost all of which I agree), there's another reason why VCs are willing to do this besides avoiding a confrontation with a celebrity entrepreneur (and possibly getting cut out of a great, future deal).  This other reason has to do with a little-known corner of the asymmetric risk/reward structure of the venture business, and here's how it works.

Starting with the blindingly obvious: VCs get rewarded when they generate high returns on invested capital.  If a VC doesn't make a lot of money on a deal, however, the way-way-off-in-the-distance second prize is getting one's money back (the euphemism is "getting one's bait back" -- no idea where  that came from; it always struck me as odd: that one's investment was some kind of "bait").  That is, surprisingly, considered not a bad outcome.  "At least I didn't lose my money!" is not something about which to brag, but it's also not an embarrassing admission for a VC.  Sort of like kissing your sister on the cheek.

But, importantly, there is no third prize, not even way-way-way-way off in the distance. 

This means that getting, say, a third of one's money back is considered a wipe out, and a professional embarrassment equivalent to losing everything.

So, if there is any money left short of an amount that would "get one's bait back", the psychological/professional incentives of the VC are (1) to go for broke and  (2) hope that a miracle happens and a positive return is generated.  If it does, the VC is a hero.  If it doesn't, the VC is certainly no hero, but he's no worse off, having lost all his "bait", in the eyes of his partners and colleagues than if he'd (merely) lost most of the "bait".  The fact that miracles like this almost never happen doesn't change the dynamic.

A very successful VC friend of mine expresses this as:  "You can only lose your money once if you fail, but you can make many times your money if you succeed."

This dynamic, or asymmetric risk/reward structure, has been recognized in corporate law for a long time.  It is why the law provides that, once a company is approaching the zone of insolvency, the fiduciary duties of the Board shift from favoring the shareholders to favoring the creditors.  When a company is insolvent, the shareholders, who are unlikely to get anything in a liquidation, have an incentive to throw a "hail Mary" pass for two reasons:  (1) if it works, they win, and (2) if it doesn't work, they are no worse off than they were before (i.e., they wouldn't have gotten anything in a liquidation, and that's what they're now getting). On the other hand, the creditors have no upside if the "hail Mary" works because they never get paid more than their principal and interest, no matter how high the upside.  But, they do have significant downside if the "hail Mary" uses up valuable cash on which they, by law, had the first priority claim.